In contrast, downward sloping futures curves, in which investors roll from more expensive to cheaper contracts, help returns. During the 2000s, negative roll yields subtracted almost 8% annualized from commodities futures returns. By contrast, during the 1970s, roll yields added 4.62% annually to returns. "Roll yields have been declining for the last four decades," as spare capacity has shrunk, Settles asserts. "This is not just a blip, but a change in fundamentals."
Finally, Settles argues that natural resources stocks have shown almost as much sensitivity to changes in the rate of inflation as commodities have over the last ten years. From 2001 through 2010, the correlation of annual percentage changes in the S&P GSCI and the S&P North American Natural Resource Sector versus the CPI were 0.76 and 0.73, respectively. This undercuts the argument for commodities as a superior inflation hedging tool, says Settles.
But correlations are not the whole story. It comes down to the difference in returns, Settles says. Fund Evaluation Group's Busken notes that several years ago he found that only nonrenewable commodities such as oil, gas and gold keep pace with inflation over the long term. Between 1951 and 2003, while the CPI increased 598%, the spot prices of most commodities, including silver, copper and many agricultural commodities, fell far behind. Investors need to be selective in choosing their inflation hedges, he says.
Busken is a proponent of private equity exposure to commodities such as energy exploration and development partnerships. "If you can handle the illiquidity, private equity is the best way to go for long-term investors," he says. Not only should investors earn a premium for locking up their money, but generally they're getting direct ownership of the commodity.
Other investment managers also favor equities over futures in a commodity allocation. The headwind to returns posed by upward sloping futures curves is "just a killer," says Ben Inker, the head of asset allocation at Grantham Mayo Van Otterloo in Boston. "If you're going to get exposure, it's better to own the companies that produce the commodity," he told a Morningstar Investment Conference panel in June. GMO's Jeremy Grantham has been an outspoken proponent of long-term investing in commodities, despite the near-term risk of a sell-off due to a decline in the Chinese economy. Noting that commodity futures give investors simple price exposure, Inker noted, "With equities, you get a return."
Similarly, Richard Fullmer, an asset allocation strategist at T. Rowe Price Associates in Baltimore, says that the uncertainties surrounding roll yield, as well as the firm's experience analyzing natural resource equities, has led his group to advocate for the use of "real asset equities," which include real estate and infrastructure stocks, in the firm's portfolio products. "For many years, there was an advantage to buying futures," says Fullmer, "but it is unclear now whether the turn to negative roll yields is cyclical or more structural. The returns investors can expect from futures to us is uncertain," he says.
Still, other advisors and strategists continue to favor commodities futures as a better pure play on commodities prices as well as a better inflation hedge.
Steve Jones, a principal in the manager research group at Mercer Investment Consulting in Chicago, notes that the correlation of returns between the GSCI, which has a large energy component, and the S&P energy sector is not that high. Since 1989, the rolling monthly correlation between the S&P energy sector and the GSCI has been 0.53. "At only about 50%," says Jones, "equities are not the best way to get exposure to commodities. We prefer direct exposure to commodities futures."
Moreover, while both the GSCI and the S&P Natural Resources Index have been highly correlated with the CPI in recent years, the GSCI has a higher correlation-0.75-to the CPI on a one-month lagged basis than does the natural resources index-0.50. For example, the total return of the GSCI in January was highly correlated with the CPI in February. That makes sense given that the GSCI feeds almost directly to the CPI, notes Jason Thomas, chief investment officer at Los Angeles-based wealth manager Aspiriant.
Thomas notes that Aspiriant uses all three methods of gaining exposure to commodities-futures, public natural resources stocks and private equity. Natural resources stocks have important sources of return that are not captured in the inflation measures, he says. However, commodities futures are the way to go for investors looking to hedge unexpected price inflation. "We use futures as the purest form of exposure to unexpected increases in spot prices," he says.
He and others also note that tweaking passive approaches to managing commodities futures can minimize issues associated with upward sloping futures curves. In 2006, Aspiriant asked Goldman Sachs to build an enhanced commodities futures index designed to deal with the drawbacks in the benchmark. Goldman then issued an exchange-traded note based on the enhanced index to which Aspiriant has directed $100 million in client assets.